March 27, 2009

I distinctly remember sitting in Sherwin Rosen’s Economics 301 Price Theory course at Chicago (in Winter ’82 quarter, I think), listening to him lecture about the informational role of the price system. He was talking about relative prices, and all of sudden the volume of his voice rose startlingly, and he almost shouted: “And that’s why inflation is bad. It F*CKS UP relative prices!” (Sherwin is truly missed, by me in particular.) And, if you screw up relative prices, Sherwin continued, you cause the misallocation of resources. These inefficiencies can be very costly. (Bertrand Russell once said that “efficiency is the highest form of altruism.” Thus, screwing up relative prices is a profoundly un-altruistic act.)

Reading these two posts from ThinkMarkets brings Sherwin’s outburst oh-so-long ago to mind. Mario Rizzo notes how the Fed’s extremely aggressive monetary policy (which bears a major risk of massive inflation) is distorting relative prices. In particular, it is attempting to inflate housing prices (relative to the prices of other goods and services) by reducing other prices (interest rates). Worse, it is doing so deliberately, in an effort to influence the allocation of resources in the economy:

On the other hand, demand is being stimulated by Fed purchases of MBS.As of March 18, 2009 the Fed had $236 billion in such securities on its balance sheet. In addition, a $8,000 tax credit for first-time home-buyers was included in the stimulus law. More purchases of MBS are forthcoming. This should cause mortgage rates to fall further (although some of that fall is already being seen). And who knows what is coming after that?

(The tax credit will expire in December; that will reduce demand. I doubt this will be a big factor either on the upside or the downside.)

So whatever equilibrium the market is tending toward, it is not a long-run sustainable one. This is because real interest rates will rise in the few years due either to inflation or the Fed’s sales of MBS to prevent inflation.

If the first is the mechanism, then we shall probably see another housing bubble bursting. This is because the Fed will not begin selling securities until it sees sign of overall inflation (and not simply price rises in particular markets). This will be too late to prevent a new housing boom.

If the second is the mechanism, then the Fed will have simply succeeded in slowing down movement to the eventual lower-price equilibrium.

Overall, it is good news that housing prices are falling and sales rising. Yet the Fed will manage to turn this good news into bad:just the opposite of the “Keynesian miracle” – bread into stones.

This is to take a very Olympian view of the operation of the economy, with the Fed in the role of the All Seeing, All Knowing, All Powerful Zeus. But, as Mario notes, these interventions are impeding the movement of the economy to a sustainable equilibrium; perpetuating the distortions that materially contributed to the current problems in the first place; and thus laying the groundwork for a future crash (one, by the way, that will wash over an already weakened banking system.)

In other words, this is an exercise in what I termed NeoSoviet Economics; an attempt to dictate market outcomes in order to sustain an unsustainable status quo. This is unlikely to turn out well.

We need resources to flow out of bloated sectors (real estate and construction first among them, but autos and many parts of the financial sector as well). This is never an easy process. Indeed, it is inevitably painful. But it is necessary to compare that pain, to the pain of alternatives. Distorting relative prices and impeding the flow of resources to higher value uses will only make things worse.

The Fed could use some of the wisdom of Canute, who knew better than to think that he could command the tides. The Fed’s efforts to control the Fundy-like economic tides we are currently encountering are likely to be worse than futile; they will instead be destructive, and exacerbate and perpetuate economic dislocations rather than alleviate them.